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401(k) Testing: What is That About?

by Tom SmithMay 9, 2013 10:14 AM

I receive this question very often, especially at the beginning of each year. The IRS requires any company with a 401(k) plan to conduct annual compliance testing.

The testing is conducted after the plan’s year-end. For most plans, this is 12/31.

Why is plan nondiscrimination testing important?

According to Transamerica Retirement Services, "Nondiscrimination testing mandates were added to the rules governing 401(k) plans to ensure that these plans are not designed to economically benefit only highly-paid personnel, but are fair for all employees. Not meeting these mandates, or failing to correct any failed year-end compliance test, could mean substantial penalties and possibly even disqualification of the plan's tax-exempt status."

Simply put, 401(k) testing is required to make sure all employees benefit from the plan equally, regardless of their income level. When plans aren’t tested or fail the test, or when plan problems aren't corrected, the company can be penalized.

How does 401(k) testing work?

401(k) testing involves examining the benefits received by all employees. For the purposes of these tests, employees are grouped into three categories:

  • Key Employee - anyone with at least a 5% ownership stake in the company (either last year and/or current year) or a direct relative (spouse, parent, or child) of someone with a 5% ownership stake.
  • Highly Compensated Employee (HCE) – for 2013 testing, anyone who has made $115,000 in 2012.
  • Non-Highly Compensated Employee (NHCE) - anyone that doesn't fall into the other two categories.

*Please note that all Key Employees are also considered Highly-Compensated Employees, but not all Highly-Compensated are considered Key Employees.

What do the tests entail?

These two tests are probably the ones that effect employers the most.

    1. Average Deferral Percentage Test (ADP)

This test takes the average deferral rate of the HCE and compares it to the average deferral rate of the NHCE. The HCE can only contribute so much more than the NHCE.

If you are a HCE and contribute more than the maximum allowed, then you could be subject to a refund or the company might have to make contributions into the NHCE accounts.

    1. Top-Heavy Test

This test is a little different, in that it is always conducted for the upcoming year. The numbers used are from 12/31/12 to determine if you are Top-Heavy for 2013.

Key Employees cannot control more than 60% of the entire plan’s assets. If they do, the company will have to make up to a maximum of a 3% non-elective contribution to any eligible employee of the company—even those who aren't participating in the plan.

How do I make sure I’m abiding by the rules?

You need to make sure you are getting the proper guidance from your retirement provider. You also need to take ownership of your plan. Additional Plan Data forms are extremely important, because things change from year to year. It’s important to have the most up-to-date information so that your retirement provider can correctly conduct your testing.

GMS, as a PEO company, is able to offer clients our 401(k) plan. We assist with administering the testing. Instead of just handing you the results, we will go over them and provide advice. Every company is in a different situation.

Are you getting the right guidance on your 401(k) plan?

"Numbers and Finance," © 2011 Ken Teegardin, used under a Creative Commons Attribution-Share Alike 2.0 Generic License.

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Benefits | Risk Management

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